BHP can ride out price storm

Iron ore has had a very volatile past two months, which accelerated towards the end of August when the spot price plummeted through the psychological support at US$100 a tonne to end the month at about $US90 per tonne.

The spot price has now fallen over 30 per cent since June and is a long way from the peak of US$190 per tonne in February 2011.

The impact of this can readily be seen in the share prices of the major iron ore producers, many of which are trading at their lowest levels in nearly three years (for example, Rio Tinto (RIO) $48.37, Fortescue Metals (FMG) $3.47 and Atlas Iron (AGO) $1.355).

Should the iron ore price remain depressed there is very real risk that some of these companies will need to go back to the market to raise funds to strengthen their balance sheets ahead of further planned expansions.

To date, the management of our major iron ore miners (with the notable exception of BHP-Billiton) are largely continuing with their expansions plans in the face of declining prices and a deteriorating outlook.

They all seem to expect a near term recovery in prices back closer to $US110-120 per tonne. But the fact remains that our miners are 'price takers' and have little control over the iron ore price they receive.

So expect an increased emphasis on managing costs and expenditure going forward.

What is of concern beyond investors losing money through owning iron ore shares, is that the Australian Government's budget and projections have been calculated on taxes and returns from inflated commodity prices.

It is becoming increasingly clear that they are not going to receive the amounts of money predicted, which will put pressure on the so called budget surpluses that will then filter through to other parts of the economy (that is, spending cuts, increased taxes in other areas).

It is already daunting that many people are finding it hard to get by day to day because of the already high cost of living and taxes when their money is being pumped into the system from the mining boom, which is largely funded by the main export of iron ore.

If this falters and the Government is found short on its budget projections they will probably seek to increase taxes in other areas or at least wind back on some of their current subsidies/spending plans.

Now to make myself clear, I suspect the spot iron ore price may bottom and even recover a bit from these levels as it does seem to be a capitulation at the moment that is generally followed by a recovery.

There will still be demand from China, although slowing, and the majors (BHP and RIO) will continue to profit by producing iron ore at a cost of about $A50 a tonne.

I do not however expect prices to return to the previous highs, especially as planned expansions push the market into oversupply in the next couple of years.

For the dozens of smaller iron ore hopefuls seeking to get into production they have probably missed the boat.

If you are looking to invest in this space, we suggest you focus on the existing low cost producers' (with diversified commodity exposure) that are best placed to ride out the storm. And BHP-Billiton is on the top of that list.

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